The most popular retirement account of the past decade is the Roth IRA. It offers tax-free growth, tax-free withdrawals after age 59.5, and no minimum distribution requirements. Unlike traditional IRAs, Roths are funded with after-tax dollars, which means there is no deduction for a contribution. Evaluating whether to contribute to a pre-tax or Roth IRA is a common exercise. Many are drawn to the upfront benefit because of the tax savings and/or they expect their rate will decline in retirement. However, if your time horizon is decades, Roth savers are much more likely to end up with more after-tax money. Further, when you consider that Roth IRAs have no required minimum distributions and offer flexibility to save for education expenses, the benefits are superior.
Sounds like a great idea – what’s the catch?
Unfortunately, the IRS sets an income phase-out for Roth contributions. In 2021, a single filer’s income phase-out starts at $124,000 of Modified Adjusted Gross Income (MAGI). For joint filers, the phase-out begins at $196,000 (contributions are disallowed if MAGI exceeds $139,000 for single filers and $206,000 for married couples, respectively). The phase-out ranges are typically adjusted higher by a few thousand dollars annually.
However, if your MAGI surpasses those levels, you may not be out of luck! That is because there are no restrictions on converting traditional IRA balances to a Roth – hence the backdoor Roth strategy.
A backdoor Roth contribution is a two-step process:
Make a non-deductible contribution of up to $6,000 to a traditional IRA ($7,000 if 50 or older). In order to be eligible, you must have earned income that is equal to or greater than your contribution amount. There is an exception for non-working spouses.
Convert the non-deductible contribution to a Roth. This is essentially a transfer from the traditional IRA to a Roth account. If you have no other funds in a pre-tax IRA, which includes SEPs and simple IRAs, the conversion is tax-free.
If you do have a balance in a pre-tax IRA, a backdoor contribution gets complicated because of the pro-rata rule. The crux is that a distribution from a non-Roth IRA must contain the same proportion of pre-tax and after-tax dollars as the account holder has across all of their non-Roth IRAs.
Suppose Suzy has $54,000 in a rollover IRA that she funded last year from an old 401(k) plan. Suzy earns $400,000 annually, so her friend Mary tells her that she should utilize a backdoor contribution strategy. Suzy takes Mary’s advice and makes a non-deductible contribution of $6,000 to a traditional IRA. Following that, she converts her $6,000 contribution into a Roth IRA that she opened years ago.
Suzy is under the assumption her conversion is exempt from tax. However, since she has a balance in a pre-tax IRA, part of her conversion is taxable. At the time of conversion, 90% of her IRA funds were pre-tax. That makes 10% of her conversion tax-free and the remaining 90% taxable. Not a desirable outcome, as Suzy is paying tax on 90% of the converted funds twice! The $6,000 she originally contributed was taxed as earned income and now she must report an additional $5,400 of income on her tax return.
There is a good way around the pro-rata rule. If Suzy had kept the old 401(k) funds within the plan or rolled them into her new employer’s retirement plan, she would be eligible for tax-free conversions. Employer-sponsored retirement accounts, as well as inherited IRAs, are not subject to the IRA aggregation standards.
The backdoor Roth strategy was previously considered a loophole that potentially violated the step transaction doctrine. However, Congress blessed the backdoor Roth strategy, cementing it as a legitimate method for higher income households to accumulate tax-free money over a lifetime. These small annual contributions can be a powerful means of retirement savings!
Updated September 2021